Saturday, December 17, 2011

Are the Public Ignorant of the Nature of Fractional Reserve Banking?

The short answer is, of course, that there is no doubt some degree of ignorance – perhaps even a great degree of ignorance – about the nature of fractional reserve banking amongst the public, but as to what percentage of people are ignorant I would prefer to see more than one well-sampled survey before giving definitive numbers. One survey that is available from the UK that can be read here (“Public Attitudes to Banking. A Student Consultancy Project by ESCP Europe for The Cobden Centre,” June 2010) finds that 74% of people surveyed (in August 2009) thought that they were the legal owner of the money in their FR current account (p. 6). A further 16% thought that both the bank and the depositor were joint owners of the money (p. 6). Only 8% knew that the bank was the legal owner (p. 6).

Now 74% is indeed a high percentage, but what is very interesting to me is that, despite this number, 61% of people surveyed also said that they did not mind the bank lending out some of the money in their current account as loans (p. 8)! Only 15% said that they keep money in a FR current account for safekeeping (p. 5).
Furthermore, only 33% thought that the bank lending out some of the money from their current account was wrong because they did not give permission (p. 8). This strongly suggests to me that in fact if people were properly informed of the legal nature of FR banking (with the proviso that their debt/deposit is insured), they would not object to the actual practice of FR lending or its legal status. People want banking services with a return on their money. A majority do not mind that the bank lends their money, even though a majority most also think that they remain the legal owner of the money.

Now of course the objection that can be made to fractional reserve banking is that a majority (at least from this UK survey) do not understand the legal nature of the FR contract as a mutuum. In response to this:

(1) The existence of bank runs strongly suggests that historically many people have understood the basic facts behind fractional reserve banking. Bank runs were frequent during financial crises before the 1930s when modern fiat systems and deposit insurance generally became the norm. Now I cannot resist posting this video of one of the best movie bank runs I can think of, because it really does illustrate the issues involved.

Even as a fiction, it is illustrative. In order for such bank runs to have occurred, many people must have understood that the banks do not operate on a 100-percent-reserve basis. Nor am I insensitive to the suffering and negative economic effects caused by the failure of a FR bank (see point (2) below).

I suspect that before the 1930s there was probably a greater degree of public understanding of the nature of FR banking (though I would need empirical evidence to prove it), but in the modern world, as bank runs virtually disappeared, public ignorance has grown. Another crucial point is that before the 19th century, ordinary people did not normally use FR banking systems. FR banking was limited to the wealthy, the commercial and mercantile classes and businessmen, people who had a much better understanding of finance and the contracts they were entering into. There is, then, a strong case to be made here that the widespread ignorance of the legal nature of FR banking has only become a problem in the modern world, as ordinary people have come, in vast numbers, to open FR accounts with the money they earn.

Furthermore, people are surely aware that the money they “withdraw” from their FR reserve account cannot be the same money they deposit in a physical sense. The money you withdraw from an ATM is not the same money you may have physically deposited or that was credited to your account by electronic transfer from your paycheck. It would take but further reflection to see that the belief that your FR account is a mere bailment cannot be true.

(2) If you have failed to read your fractional reserve bank contract, whose fault is that? As a client, you ought to understand the contract that you sign. If, for example, I contract with you to lend you my wheat as a mutuum loan where I have signed a contract that explicitly states that I transferred ownership of the grain to you, but then I think that it is a mere bailment, then this is my misunderstanding. I would be a poor and incompetent businessman. There is no fraud involved, simply ignorance and misunderstanding on my part. This does not mean that there is no consequentialist moral argument for intervening to stop the distress and economic disaster caused by the failure of a fractional reserve system: on the contrary, I hold that there are strong consequentialist moral arguments for government intervention to stop the pro-cyclical nature of unregulated FR banking which lacks an effective lender of last resort. Without modern fiat money, a well-regulated financial system, deposit insurance and a central bank ready as the lender of last resort, fractional reserve banking can be extremely destabilizing and has led to disastrous bank collapses and recessions in the past.

(3) The solution to the problem of modern people not understanding the nature of fractional reserve banking – if we perceive it as problem – is simply legislation to make banks explicitly explain to potential customers when they sign a contract how FR banking works. Specifying to clients that the property rights to the money had passed to the bank, and in return an IOU or credit had been granted to the depositor, that the bank lends your money out, and that it will return not the same money, but other money from its reserves will solve the moral problem of clients not understanding the nature of FR banking. Under these circumstances, FR banking is not fraud. It is a free contract. There was very probably a strong moral argument for enforcing such legislation in the days before deposit insurance, so that people understood the risks involved in FR bank accounts.

In practical terms, however, modern FR systems are protected by deposit insurance and the central bank as a lender of last resort: there is no need to warn depositors that they could lose their money, because that simply does not happen these days. The issue of explaining FR banking to consumers is a far less pressing moral issue than it is made out to be by opponents of FB banking.

13 comments:

1)A Bank run could have easily occurred when people said 'Oh, so the banks DON'T have the money in the vault? Oh shit!' or at least with some people. Not saying this is the entire reason.

2)Yes, it is the person's fault. Again the misconception can boil down to what people consider a bailment. Remember the discussion about grain warehousing? A check that says $100 dollars or a bank note that says Will Pay on Demand $100 the public can easily perceive as a money substitute/warehouse receipt. Whether or not they have legally/"peacefully" developed that way is open to interpretation of what is a bailment (most bailment/bank debt law is grounded on the assumption that if it isn't sealed in a bag, then that means its not a bailment ipso facto-not saying this is right or wrong, but thats just how it is). Economists and legal historians can argue over whether "Will Pay to Bearer on Demand X dollars" or bank contracts/bailments etc, but the common everyday man does not (and cannot, out of opportunity cost) concern himself with such things.

3)I agree. Although I wouldn't consider it "legislation", but mainly elaboration/enhancement of private law. However, given the explicit "choice", almost everyone in todays world with deposit insurance and a central bank will choose FRB, because if the bank fails, they will get bailed out, and people will want some inflation hedge (interest) to combat against secular central bank inflation.

As for surveys, see:

"www.cobdencentre.org/?dl_id=67"

And I more or less agree with Kinsella on this issue:

"The economic arguments in favor of FRB and its usefulness seem flawed to me, but in my view it is not necessarily fraudulent, so long as full disclosure is made. (See my post Fractional-Reserve Banking, Contracts of Deposit, and the Title-Transfer Theory of Contract.) But is full disclosure actually made? Are customers aware? Proponents of FRB often say that FRB “depositors” “are” aware of what is done with their money since interest is paid on it. In actuality what they are saying is that such customers are “deemed” to have constructive knowledge of the fact that their money is lent out, since they “ought to” know that this is implied by the earning of interest. But this is assuming too much economic sophistication on the part of the typical bank customer and substituting the legal fiction of constructive knowledge for actual disclosure. It is obvious that most banking customers are not aware of the nature of modern centralized FRB, or of the legal status of “their” “deposits.” One reason for this is modern deposit insurance, which reduces the need for “depositors” to consider the question in the first place. Another is the complexity and subterfuge of the current state-regulated and controlled banking system. As for actual evidence, a recent survey conducted in the UK concludes that most people (74%) think they own the money they deposit in a bank. Which, of course, they do not"

That clip from the movie wasn't a bank run. That place was a housing fund in which people purchased shares and the proceeds of which were used to lend for housing loans. Like a mutual fund, but for housing loans only.

As the deposit is insured by the state isn't it true that 'de facto' the individual does always remain the owner of the money. Regardless of what happens, and the legal niceties, they will always get their money back.

I would suggest that pragmatically the money is bailed below the deposit limit, and only 'at risk' in any sense above that limit.

The insurance system just means, de facto, that the money is bailed in a 'dematerialised' form.

Most people are also ignorant of 'caveat emptor' - and what that means. That's why we have consumer protection legislation.

"That place was a housing fund in which people purchased shares and the proceeds of which were used to lend for housing loans. Like a mutual fund, but for housing loans only."

Yes, it wasn't technically a bank. The institution was indeed a thrift, or savings and loan association (or S&L). To the extent that the accounts were savings accounts and term certificates of deposit with contractal time periods, of course it is inaccurate.

But this is splitting hairs - it still illustrates the point. When James Stewart (as the charater George Bailey) says "you're thinking of this place all wrong, as if I had the money back in a safe," that is a perfect illustration of the public misconception about FR banking.

"As the deposit is insured by the state isn't it true that 'de facto' the individual does always remain the owner of the money. Regardless of what happens, and the legal niceties, they will always get their money back."

While the CODS aren't money, the shares of stock that people receive in exchange for depositing money in a S&L the public treats as money. The legal technicality that they weren't exactly banks (defined by regulatory agencies) is what drove Friedman and Schwartz to not include them in their money supply in their treatise.

You have a descending list of things that are or could be used as money in the sense of a means of payments/medium or exchange or store of value. By the time you get to the bottom of the list it is rare for the thing in question to be used as money (especially if it not negotiable). E.g., in a commodity money world,

Yeah, Bills of Exchange and Promissory Notes can be used, but they have to be certified and are not widespread (if they are widespread, then they become money). Stocks and bonds are not necessarily money, mainly because they do not have a fixed price. If apple "froze" the price of its stock at $25 and said it always stood ready to exchange it for cash, then if there was enough confidence in apple the stock would become money. If the government today was to issue an edict stating "All loans will be insured by the government at par value", then people would start exchanging all sorts of securities as part of money and the money supply would rapidly inflate. (aside from all the other risk problems)

I think the strongest definition of money is that which uses instruments that "in themselves" are exchanged for a fixed value of money, not necessarily liquidity (and the public always perceives is money proper or can be exchanged for it). The problem with liquidity, in my view, is that the definition really has no end and it becomes too broad, especially since plenty of goods that are liquid do not have a fixed value.

"Bills of Exchange and Promissory Notes can be used, but they have to be certified and are not widespread (if they are widespread, then they become money). Stocks and bonds are not necessarily money, mainly because they do not have a fixed price .... I think the strongest definition of money is that which uses instruments that "in themselves" are exchanged for a fixed value of money"

A negotiable bill of exchange is a promise to pay x amount of dollars, so it is redeemable for the final means of payment by the last holder of it for a fixed price. Government bonds also can be redeemed at their maturity for a fixed price, although the prices on the secondary markets for them might flucuate as they are exchanged, just as the bill of exchange's price can be discounted.

So here you're saying that only something that always buys X amount or can always be used to obtain x amount (the same as its face value) is money. A $10 bill always buys $10 worth of goods or can be exchanged for another $10 bill or two $5 (and so on).

Therefore "money proper" is only this. In this case even the demand deposit (a debt instrument) will have to count as money.

I'm a little confused by your post, I'm not sure what you're criticizing.

I adhere to Rothbard's definition of the money supply: Something is money if the public perceives it as redeemable for the money proper at a fixed rate (the par value of money).

A Bill of exchange is not money in the sense that it is always redeemable for a fixed amount of cash (you have to wait until the maturity), or a fixed amount (entrepreneurial risk of me paying you back). Stocks and bonds all have fluctuating prices and the public does not perceive them as redeemable for a fixed amount. Some bonds, like U.S savings bonds, are always pledged to be redeemable at some fixed (but penalty rate) until maturity.

"So here you're saying that only something that always buys X amount or can always be used to obtain x amount (the same as its face value) is money. A $10 bill always buys $10 worth of goods or can be exchanged for another $10 bill or two $5 (and so on).

Therefore "money proper" is only this. In this case even the demand deposit (a debt instrument) will have to count as money. "

Yes. Goods that the public always perceives as redeemable for money proper at a fixed rate is money.